Guest Post: Fraud Girl -Playing Dirty: The Art of Bending the Rules

Readers,

Here’s Fraud Girl’s latest article.  It’s a pleasure having her as a contributor . We both thank you for the wonderful comments and emails. Your words of encouragement and curiosity make this a worthwhile effort.

-Miguel

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Meet Playing Dirty: The Art of Bending the Rules

Welcome back. Last week’s post focused on the responsibilities of regulators in monitoring the wrong doings of firms. We concluded that following a checklist does not constitute a “completion of duties”.  Furthermore, I suggested that regulators look beyond the exterior of firms and delve into their everyday operations. Today we’ll discuss the warning signs of fraud and show how Lehman Brothers used a set of poorly constructed accounting rules to manipulate their balance sheets.

Since 2000 (but heavily in 2007 and 2008), Lehman Brothers was involved in billions of Repurchase (“Repo”) transactions. These transactions allow(ed) investment banks to borrow cash from companies and the government for a short period of time in exchange for assets valued at more then what they are receiving. At the expiration of the repurchase agreement, the bank pays back the principal borrowed plus interest and takes back their assets.

Lehman Brothers benefited from the ineffectiveness of their regulators. Having the ability to record $50 Billion of Repo 105 (and 108) transactions as sales via an accounting irregularity allowed them to lower their leverage ratios by an average of 1.8 points a quarter in 2007 and 2008. Though compliant with SFAS 140, Lehman utilized these products as ways to hide debt and defraud their investors.

In order for regulators to catch fraudulent acts, they need to recognize the ingredients of disaster. Fraud 101 introduces the “Fraud Triangle” and states that there are three elements that are required in order for fraud to occur… pressure, opportunity, and rationalization.

The question before the House is whether the regulators/auditors used the “Fraud Triangle” as a checklist to analyze Lehman’s Repo 105/108 transactions.  Let’s take a look and use this triangle as a due diligence checklist.

Rationalization

To record Repo 105/108 transactions as sales, Lehman claimed to follow SFAS 140 accounting. This statement marginally depends on a very loose and convenient interpretation. In short, compliance claiming was a guise for deceit and fraudulent behavior.

Pre-Repo 105/108s, Lehman utilized “ordinary repos” for short term borrowing needs. When purchased, Lehman would give high investment grade assets to a counterparty in exchange for short term cash. These ordinary repos were valued at around 102 – meaning that the assets were worth 102% of what Lehman was getting for them. Lehman would schedule to repay the counterparty the amount borrowed (plus interest) in exchange for their overvalued collateral. Because Lehman expected to get the assets back, there was never a reduction of them on the balance sheet. At the moment of the transaction, the balance sheet had the following effects:

Lehman would then use the borrowed cash to pay down other debts causing their leverage ratio to become neutral.

The accounting for Repo 105/108 transactions was identical to that of ordinary repos except for one difference. At the moment the assets were given to the counterparty, Lehman acted as if it sold the assets to them even though they knew they would get them back. Doing this caused the balance sheet to have the following effects:

Lehman would use the borrowed cash to pay down other debts causing a decrease in both cash and liabilities, which ultimately lowers their leverage ratio.

To book the Repos as sales, Lehman had to prove that they relinquished “control” over the assets when given to the counterparty. FASB states that if the collateralization was between 98% and 102%, a borrower preserved control over the transferred assets and could not move them off the balance sheet. The rational – Due to a low 2% haircut, Lehman has the ability to replace the assets with one almost identical to it. Since they could easily replace it, FASB states that it is considered not to have relinquished control of the assets and therefore could not be removed from their balance sheet.

For a Repo 105/108 transaction, Lehman believed (and accounting rules agreed) that they would not be able to easily replace an asset valued at 5% or 8% more than what they got for it. This interpretation results in a relinquishment of control, which is then classified as a “true asset sale”.

In other words, Lehman chose the 5% and 8% haircuts for a reason – to allow them to account for the debt as sales via SFAS 140. Furthermore, using these transactions was more expensive than using ordinary repos. Lehman could borrow $100 by giving up only $102 instead of $105. Why would a company take the more expensive route to get to the same outcome?

Management at Lehman realized that this loophole would allow them to hide billions in debt. Their rationalization was simple – we are abiding by the rules and we are therefore not doing anything wrong.  Unfortunately, the use of accounting loopholes is anything but the right thing to do, especially if they hide the economics of an enterprise.  Strike One!

Opportunity

To finalize a repo transaction as a sale under SFAS 140, FASB requires that the transferor (“Lehman”) obtain an opinion letter from a law firm confirming the true sale and relinquishment of control over assets. Lehman could not find a United States law firm that would draft an opinion letter for their Repo 105/108 transactions (i.e red flag).

A London based law firm, however, agreed to draft the letter under UK Law. To facilitate the process, Lehman created Lehman Brothers International Europe (LBIE) to execute the Repo transactions in the UK. LBIE would either use assets owned by LBIE or assets owned by, and originated from, a United States-based Lehman entity for the Repo 105 transactions. Consequently, with the 5% and 8% haircuts and an opinion letter from a UK law firm, Lehman now had the opportunity to cheat its shareholders. Strike Two!

Pressure

At the height of the financial crisis, Lehman was under intense pressure to shrink their balance sheet and lower their leverage. Their involvement in the sub-prime mortgage industry had caused them to accumulate large sums of debt and they had no means to repay them. The pressure was severe and the actions they took to disguise their problems were even greater. In an email from former CFO Erin Callan to former CEO Richard Fuld, Callan said:

“[W]e may get a very short leash if we show up with a rough quarter if we do not get the balance sheet exercise completed. No matter what, the skeptics are focused on our balance sheet and that is the key to the future. . . . I know we are saying it over and over but we HAVE to deliver on the balance sheet reduction this quarter and cannot give any room to FID for slippage”

The creation of Repo 105/108 transactions helped them to cover what would have been a total of $50 Billion in debt. They used these transactions at quarter end to help Lehman “deliver on the balance sheet reduction” that they so desperately needed. They were addicted to these Repos and continued using them throughout 2007 and the first two quarters of 2008. As demonstrated by the chart below, Lehman would substantially increase their purchases of repos at quarter ends in order to meet targets.

It’s no surprise that management would go to such great lengths to utilize these transactions. They had incentives to do well: higher compensation, increasing stock price, and an edge over competing banks. Lehman Brothers had to perform well to maintain their status in the investment banking world. Unfortunately for them, the only performance taken was one of trickery and mistrust. Strike Three!

Checklists, Fraud Triangles, and Proper Regulation

Lehman Brothers can huff and puff about compliance. But as I have demonstrated, compliance and proper economic representation are different endeavors. Lehman followed the rules and shrewdly exploited loopholes to lower leverage ratios. Which begs to question why didn’t auditors and watchdogs catch the issues. My take — regulators and auditors failed to use common sense, skepticism, and a checklist such as the fraud triangle to catch dirty accounting in the making. We must remember; when companies are pressured to perform in the short term and billions of dollars are at stake frauds are likely to occur.

See you next week.

-Fraud Girl

Follow me via twitter at: Fraudgirl

Email me your comments and thoughts at:    fraudgirl [at] simoleonsense.com